Crawling Road

The topic of safety of keeping all your funds at Vanguard came up recently on the Bogleheads forum and an interesting post from The Oblivious Investor:

Is it Safer to Use Multiple Fund Companies?

This is a great post with an interview from a Vanguard PR rep about their internal controls and laws in place to protect investors. So I am not being critical of the post, just pointing out some things that I disagree with.

First of all, keeping all your money at one company or one fund provider is a very bad idea. I’m sorry because I know that it’s more convienent, but it’s just how I feel. I strongly believe in Institutional Diversification. That is the idea that you split your money up between financial services company and the funds they provide.

Institutional diversification is more than about fund managers commiting fraud or other shenanigans with customer funds (although that has happened in the past as MF Global customers just found out). There are a lot of other unknown risks that can show up as well. Some examples:

1) Your account is compromised and access to your funds is frozen while it is sorted out. It can be identity theft from some rogue player overseas, or (more likely) someone you know. You will likely get access to the funds soon enough, but with more than one company it is unlikely the perpetrator will gain access to all your funds in one fell swoop. And if they do, you have two companies to work out the problem with and one of them likely will handle it faster than the other so you can regain some control.

2) Physical attacks against infrastructure are very real as shown on 9/11. Directed cyberattacks against infrastructure affecting large numbers of accounts at a financial services company are also all possibilities. Again, having more than one company diversifies this risk of being locked out of all your money at once.

3) A natural disaster could happen to affect the company where you have all your money. Earthquakes, hurricanes, etc. are all possible and would be very bad for certain parts of the country where many financial sector companies are based.

4) Lastly, but most importantly (and likely) there is not so much fraud as there is just sheer manager incompetence. SIPC coverage and other legal protections do not do anything if the fund managers do something dumb like Schwab’s YieldPlus fiasco, the Reserve Fund breaking the buck in 2008, or even Vanguard’s own Total Bond Market Fund in 2002 that undershot their benchmark due to manager error. Keeping all your money in one fund type at one provider opens you up to this kind of manager risk that has absolutely no protection of any kind.

Just last week JP Morgan reported a $2 Billion dollar loss due to nebulous “trading errors” that employee(s) committed. Would you be covered if this kind of trading error happened to your fund? Maybe, but maybe not. It all depends on what the error was and whether the company management wants to make good on it. In summary, manager risk is very real and very dangerous if you concentrate your bets in one company.

If there is a problem in a fund the first thing that happens is a lot of finger pointing. Then the lawyers come in. Then the judges to sort it all out. It could take years to resolve some of these things. I had one commenter on my blog discuss what happened to him in this case:

Chasing Yield With Your Cash

Everyone should follow craigr’s advice. I always took cash safety for granted until 2008 when I lost a substantial sum as part of The Reserve Fund fiasco. I can vouch first hand that the media really played down how serious and widespread the problem was. What I basically learned was that there is a lot more risk out there then people realize and when things go wrong you will get virtually no help from the agencies that are supposed to be looking out for you. For the rest of my life my cash will be in FDIC/NCUA accounts (never going over deposit limits per bank) and in US Treasuries.

(read the comment thread there for more details)

The Reserve fund has now made whole (mostly) the people invovled, but it was a harrowing experience I am certain for those involved.

Here is what someone else wrote on the forum about his losses at Lehman:

Lessons from 2008

…in September 2008, 50% of my “cash equivalent” position was in Principal Protected Notes issued by… Lehman Brothers! I lost 80% of that position. All in all my main investment portfolio (the “money not afford to lose”) was down 40% which was the same as if I had been 100% in a stock index. This was a slap in the face considering the time I had spent following the market and managing the portfolio and carefully mitigating my risks with “cash” positions…

I am not posting these things to be critical of the decisions because they were completely unknown to the investors. Just pointing them out so we can all learn about these risks and take sensible precautions.

The unpredictable happens all the time in investing. Having your money spread around is more likely to give you options to deal with the extraordinary that you won’t have if it is all at one company and that company is having the problem. In summary:

History does not support the idea that entrusting all your life savings to one financial institution as being a good idea.

Vanguard is a great company and I don’t expect any problems, but the prudent decision is still to not keep all your money at one financial institution or fund provider. Hate to be the bearer of bad news, but that’s just the reality of things.

I call the above “Extra Spreadsheet Risks.” These are risks that a spreadsheet of backtest data won’t ever show you (nor academic research).

Thing is these kinds of losses, if they happen, are much worse than whether you diversified enough into Asset X, Y or Z. Yet as remote as they may be, they do happen and you need to diversify against them. Fortunately, opening up more than one investment account is easy and a basically zero cost way of getting some protection from these Extra Spreadsheet Risks.

Of course, we cover this and other topics on how to protect yourself from these risks in our new book which I shameless plug yet again:

The Permanent Portfolio: Harry Browne’s Long Term Investment Strategy